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T.C. Memo.

2012-331

UNITED STATES TAX COURT

STEPHEN M. GAGGERO, Petitioner v.


COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21378-03.

Filed November 29, 2012.

David Blake Chatfield, for petitioner.


John D. Faucher, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HOLMES, Judge: Stephen Gaggero is a self-made man and a successful realestate developer, who in the 90s bought and moved into a rundown beach house in
Malibu that became a splendid mansion. The house was his primary residence
while he upgraded it, and he was still living there when it was sold for at

-2[*2] least three times its initial value. But before he began the upgrades, he signed
a deal with Blanchard Construction Company (BCC). BCC was in the real-estate
development business, and the essential part of the deal was that BCC would get
an equal share in any increase in the propertys value between the time the deal
was signed and the time the property was sold to a third party. Although Gaggero
would pay most of the costs of the project renovations, BCC would provide the
development services and get its half-interest in the increase if it completed its
work.
BCC completed its work in February 1997, and the house was sold a few
weeks later. The Commissioners problem is that BCC is wholly owned by
Gaggero. He disputes Gaggeros tale of a conveyance to BCC, and contends that
the property remained entirely in Gaggeros hands. To him, Gaggeros deal with
BCC is just a scheme to avoid recognizing capital gain.
FINDINGS OF FACT
Stephen Gaggero grew up with the name Stephen Blanchard, and only
changed it when he was reunited with his natural father. He did not have a
carefree boyhood, and dropped out of school in the tenth grade. He earned his
living first as a handyman in Greater Los Angeles until a movie studio hired him
as a carpenter. He was good at what he did, and movie people began hiring him--

-3[*3] first to work on their homes, and then to build them. He saved his money,
bought land, and became a developer. He continues to develop and manage real
estate today.
BCC was the corporation that Gaggero formed in 1976 to carry on his
business, and he was its sole owner and president at least between 1991 and 1997.
In its heyday BCC had as many as 40 people working for it; in the early 90s that
number was in the teens. BCC even had its own in-house counsel and accountants,
in addition to a construction superintendent, laborers, decorators, and designers.
This cases origins go back to 1990, when Gaggero bought two adjoining
parcels of land on the beach side of the Pacific Coast Highway in Malibu,
California. It was during one of Southern Californias periodic real-estate busts,
and Gaggero thought he saw a great potential gain if the next boom sounded soon
enough. Only one of those two parcels is at issue in this case, but even in that
relatively depressed market it was still worth about $3 million. But Gaggero saw
potential value far greater than the rundown house that then sat on the land. He
also looked for a way to finance the improvements that he wanted to make, and
wanted to save on any final tax bills should his vision prove true. So, before
closing, he consulted with his accountant, James Walters, on how to structure the

-4[*4] purchase and development of the property. He had worked with Walters for
several years. He trusted Walters, regarded Walters as entirely competent (Walters
was a CPA), and usually took his advice.
Acting at Walters suggestion but certainly contributing to the script with his
own experience, Gaggero as individual signed a Land Contract Purchase and Sale
Agreement and a Development Contract (Sale Agreement) with BCC. According to
this Sale Agreement, BCC would develop the property in exchange for an interest
equal to half the increase in its value less the costs of sale. The Sale Agreement
specified the propertys value as $3 million and said that BCC would not receive its
interest unless and until it finished its work or the property was sold. Gaggero then
moved into the house and made it his primary residence while BCC performed the
development work. BCC redesigned, rebuilt, and expanded the house and grounds-adding amenities such as a small golf course, stadium tennis court, new pool and
secret pathway that wound from the home through the woods to a private beach-and Gaggero personally paid approximately $1.5 million for the cost of these
improvements.1

BCC was responsible for the design, planning, permits, and day-to-day
management of the project. It hired both subcontractors and independent
contractors to perform the work. Gaggero paid many of the project costs--e.g., the
materials, supplies, and outside labor needed to complete the renovations--either
(continued...)

-5[*5] The project took years, but led to a boffo beachfront beauty of a home that
attracted international attention. BCC finished its work in February 1997 and the
property was sold for $9.6 million in March 1997 to Monticello Properties, S.A., a
Luxembourg corporation founded by a successful Flemish biochemist. To close the
deal, Gaggero executed a grant deed, a sales agreement, and a bill of sale--all of
which he signed as an individual with no mention of BCC. Gaggero reported $6.6
million from the sale on Form 2119, Sale of Your Home, as part of his 1997
individual tax return, but he didn't recognize any capital gain.2 BCC also reported
1

(...continued)
directly or by reimbursing BCC. Gaggero didnt pay BCC in cash for its
development services--BCCs payment was the part-ownership interest it would
obtain upon completion of its services.
2

Gaggero purchased a replacement house for $6.7 million within two years,
and deferred his gain under then-section 1034. Before its repeal, section 1034
provided that a taxpayer could completely defer recognition of gain on the sale of
his principal residence if (1) within two years before or two years after the sale he
purchased a new residence and used it as his principal residence; and (2) the
adjusted sales price of the old residence did not exceed the cost of the new
residence. See sec. 1034(a) and (b) (before the Taxpayer Relief Act of 1997 (TRA
1997), Pub. L. No. 105-34, sec. 312(b), 111 Stat. at 839). If the adjusted sales
price of the old residence was greater than the cost of the new residence, the
taxpayer would recognize gain on the sale of the old residence only to the extent
the adjusted sales price exceeded the cost of the new residence. Id. As we will
discuss later, what exactly the adjusted sales price of the old residence was is at
issue here. Congress repealed section 1034 in 1997 and amended section 121 at
the same time to allow all taxpayers to exclude from income up to $250,000
($500,000 for taxpayers filing joint returns) of gain from the sale of a principal
(continued...)

-6[*6] over $3 million of ordinary income (but no capital gain) on its corporate return
for that year.3
The Commissioner began an audit of Gaggero's returns for several years,
but in the end focused on this old 1997 deal, determining a deficiency on two
theories. Under the first, the Commissioner determined that Gaggero should have
reported the full $9.6 million sales price on his individual return. This argument is
based on the premise that Gaggero never in fact sold any part of the property to
BCC, at least not in any way that the Code would recognize as a sale. He argues
that BCC's interest was only that of a lienholder, little different from that which
any contractor who works on a house could get to ensure payment for his work. If
he's right, Gaggero should have reported the entire $9.6 million sales price himself.
That $9.6 million sales price was $2.9 million greater than what Gaggero paid
to purchase his new home. Thus, according to the Commissioner, Gaggero

(...continued)
residence. See TRA 1997 sec. 312(a) and (b), 111 Stat. at 836-39. (Unless
otherwise indicated, all section references are to the Internal Revenue Code in effect
for the year in issue.
3

Gaggero says that $3 million of BCCs ordinary income resulted from the
proceeds it received from the Monticello sale. We think it more likely than not that
hes telling the truth, since his testimony was corroborated by Walters and a 1099
statement that is consistent with the gross sales figure on two pages of BCCs
corporate tax return that made it into the record.

-7[*7] should recognize $2.9 million of gain on the Malibu property (the difference
between the adjusted sales price of the Malibu property and the cost of his new
residence).4
Gaggero argues the Commissioner is wrong to think that BCCs interest was
just a sort of mechanics lien. He contends that BCC acted as a developer and,
consistent with the norms of that industry, charged not for the value of its services,
but for the increase in the propertys value that its work created. According to
Gaggero, this means there was a true sale to BCC when BCC finished its work in
February 1997.
Even if Gaggero wins on the first issue, however, it doesnt necessarily
mean that he is home free. The Commissioner also argues that if Gaggero actually
sold a portion of his house to BCC, he needed to report two transactions on his
return: (1) the sale to BCC for $3 million in February 1997; and (2) the sale to
Monticello for $6.6 million in March 1997. Gaggero, however, didnt report that
first sale on his return. Under this alternative theory, the Commissioner didnt

The Commissioner calculated Gaggeros adjusted basis in the Malibu


property to be $2.167 million, which resulted in a $7.433 million realized gain on
the sale. After applying section 1034, the Commissioner acknowledged Gaggero
would need to recognize only $2.9 million of that gain. The difference between the
$7.433 million and $2.9 million would reduce Gaggeros basis in his new residence.
See sec. 1034(e).

-8[*8] allocate to Gaggero any basis for the sale to BCC, and thus asserts Gaggero
shouldve reported a $3 million capital gain on that first sale. Although Gaggero
now concedes that it might have been technically proper to report the two
transactions on the return, he has two problems with the Commissioners
determination. First, he argues that the fact that he didnt report the two
transactions separately was harmless because the two taxpayers (Gaggero and BCC)
together did report the full $9.6 million sales price: the $3 million reported by BCC
on its return and the $6.6 million on Gaggeros. Second, if there was a sale to BCC
in February 1997, the Commissioner should have account[ed] for his increase in
basis.
If the Commissioner wins on his second theory, we then need to assess the
interplay of section 1034 and those two sales. If section 1034 doesnt save Gaggero
from a deficiency for 1997, we then need to determine whether he is liable for an
accuracy-related penalty under section 6662.5

Because we decide this case on a preponderance of the evidence, we need


not decide whether the burden of proof shifts to the Commissioner under section
7491.

-9[*9]
I.

OPINION
Did Gaggero Sell an Interest to BCC in February 1997?
We start by looking at Gaggeros evidence that he sold an interest in the

house to BCC. The most important evidence is two documents dated May 14,
1991--the Sale Agreement and BCCs company resolution signed by Gaggero
twice--once as the individual selling the house and another as the president of BCC.
The Sale Agreement states that BCC will provide expertise, supervision labor,
permanent and temporary facilities, support staff, insurance, preliminary and final
feasibility studies, budgets, break downs, schedules * * * to obtain all entitlements
and permits * * * to completely design, develop, remodel, construct, landscape,
decorate and manage the property in exchange for a 50% fee-simple ownership
interest of the houses value less $3 million. BCCs interest would vest upon
completion of its work on the property or the propertys sale to a third party,
whichever came first. The company resolution authorized Gaggero, as president of
BCC, to execute all agreements as necessary regarding the development of the
property.
This all looks pretty good for Gaggeros theory. But the Commissioner tells
us to focus instead on the documents that Gaggero gave to Monticello and the
State of California in 1997, which list Gaggero as sole owner and dont mention

- 10 [*10] BCC as owner of any interest in the property. These documents include a
grant deed, sales agreement, bill of sale, owners declaration, and Form 1099S
issued by Chicago Title Company to Monticello. Each of these reports only
Gaggero as the propertys owner. They even refer to him as a single man as his
separate property, an individual as seller, and an individual [who] hereby sells.
The Commissioner argues that Gaggero cannot disavow the form of his sale
to Monticello, and that Gaggeros signature on the Monticello sale agreements is
strong evidence that whatever BCC got was not true co-ownership. He also
contends that Gaggero consciously decided to deny the existence of BCC in the
Monticello sale documents, and to structure BCCs interest as a lien, not a fee. And
he is of course able to point out a great many cases where a taxpayer gets stuck with
the tax consequences of his chosen form of transaction.
Which documents prevail? Form does not always tell us whether a deal is
a sale or something else under the Code. We look for the objective economic
realities of a transaction in order to determine whether there was a sale for tax
purposes. Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978); Houchins v.
Commissioner, 79 T.C. 570, 589-90 (1982). Things get more complicated,
though, because we have to look at state law to figure out if a taxpayer or other

- 11 [*11] party has an ownership interest in property. United States v. Natl Bank of
Commerce, 472 U.S. 713, 722 (1985). The pithy way of saying this is that state law
defines property rights, but federal law defines their tax consequences.
When deciding whether a deal is a sale, we ask whether the benefits and
burdens of property ownership have passed (or, in a case like this, become shared).
This is a question of fact determined by examining the written agreements and all
the relevant facts and circumstances. See Amdahl Corp. v. Commissioner, 108 T.C.
507, 517-18 (1997); Reinberg v. Commissioner, 90 T.C. 116, 132 (1988); Grodt &
McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1236-37 (1981). We consider
the following:

whether legal title passed;

the manner in which the parties treated the transaction;

whether the buyer acquired an equity interest in the property;

whether the buyer has any control over the property and, if so,
the extent of such control;

whether the buyer bore the risk of loss or damage to the


property;

whether the buyer received any benefit from the operation or


sale of the property;

whether the contract obligated the seller to execute and deliver a


deed and the buyer to make payments; and

- 12 [*12]

whether the buyer had a right to possess the property or an


obligation to pay property taxes.

See Grodt & McKay Realty, 77 T.C. at 1236-38.


We look at each.6
A.

Did legal title pass?

The Commissioner emphasizes that title didnt pass to BCC and that even if it
did, BCC must still hold it because title never passed from BCC to Monticello
according to the recorded deed. We do find that Gaggero didnt reveal his agency
relationship with BCC to Monticello. And even if Gaggero acted as BCCs agent,
he cannot sign the documents to transfer an interest in real estate under California
law without subscribing the name of the principal. See Cal. Civ. Code sec. 1095
(West 2007).
Gaggero argues in reply that according to the Sale Agreement title was to be
passed automatically in a self-executing process once BCC completed its
development work. Gaggero commenced negotiations with Monticello in late

Multifactor tests can be hard to handle. See Menard, Inc. v. Commissioner,


560 F.3d 620, 623 (7th Cir. 2009) (Posner, J.) (Multifactor tests with no weight
assigned to any factor are bad enough from the standpoint of providing an objective
basis for a judicial decision), revg 130 T.C. 54 (2008). But we arent juggling
these factors; were using them as possible light sources to shine on the question of
whether the deal were looking at is enough like the paradigm of a cash-for-property
deal to transfer ownership to be reasonably considered a sale for tax law.

- 13 [*13] 1996, before BCC finished its work (which, remember, was a condition for
BCCs receiving its interest in the house). It completed that work in early February
1997, and BCC passed a corporate resolution on February 8, 1997, to allow
Gaggero to act as its agent in the sale to Monticello. Those negotiations involved
many lawyers and realtors, became long and tedious, and the parties were not
certain until the very end that the deal would close. Gaggeros presentation of the
deed to Monticello without mentioning BCC was therefore reasonable.
But even if Gaggeros failure to mention BCCs interest to Monticello is
reasonable, might it still make a difference? One way of answering this key
question is to imagine what might happen if BCC had not been under Gaggeros
control--would California law recognize its interest as that of a titleholder or only a
mere lienholder?
California real-estate law considers substance over form. Bachenheimer v.
Palm Springs Mgmt. Corp., 254 P.2d 153, 158-60 (Cal. Dist. Ct. App. 1953)
(although the instrument is called a lease, and the payments are called rent, the
transaction is a sale if fee title will eventually pass to the buyer-occupant); Moss v.
Williams, 191 P.2d 804, 807 (Cal. Dist. Ct. App. 1948). According to California
law, there are situations where legal title or deed will not reflect the parties intent in
a transaction. For example, under land-sales contracts, which are similar to the

- 14 [*14] case before us, the seller holds legal title as security for the unpaid purchase
price. See, e.g., Alhambra Redevelopment Agency v. Transamerica Fin. Servs., 261
Cal. Rptr. 248, 250-51 (Cal. Ct. App. 1989) (under land-sales contracts, the seller
only possesses legal title to the property and is considered to be nothing more
than a trustee, holding the land in trust for the purchaser as security for the payment
of the purchase price until a conveyance of the legal title to the vendee is finally
made (citation and internal quotation marks omitted)). If a third party owned BCC
and wished to compel the documentation of the transfer of title it could have brought
an action for declaratory relief or specific performance under the Sale Agreement at
that time. The Ninth Circuit has held that the fact that certain documents contained
different terminology is immaterial where the intent of the parties was plain, the
purpose of the contracts was clear, and the tax consequences are therefore well
settled. See Haggard v. Commissioner, 241 F.2d 288, 289 (9th Cir. 1956), affg 24
T.C. 1124 (1955). And the Supreme Court has long established that formal written
documents are not rigidly binding in the field of tax law. Helvering v. F. & R.
Lazarus & Co., 308 U.S. 252, 255 (1939).
Even if passage of title is required by California law, we have held that a
transaction is a sale under federal tax law once theres been a transfer of the
benefits and burdens of ownership--we do not wait for the technical requirements

- 15 [*15] for the passage of title under state law to be satisfied. See Amdahl Corp., 108
T.C. at 517; Yelencsics v. Commissioner, 74 T.C. 1513, 1527 (1980); Clodfelter v.
Commissioner, 48 T.C. 694, 700-01 (1967), affd, 426 F.2d 1391 (9th Cir. 1970).
We therefore conclude that this factor is not decisively against Gaggeros
characterization of his deal with BCC as a sale, but doesnt much count in his favor
either. Title alone just doesnt illuminate much about BCCs and Gaggeros
respective rights under the terms of their deal.
B.

How did the parties treat the transaction?

The Commissioner argues that Gaggeros hiding BCCs ownership interest


from Monticello and failing to include BCC in the sale paperwork amounts to
Gaggeros implicit denial that anything was transferred to BCC, and he concludes
from this that BCC had no property right in the parcel. But, as weve already
described, other documents reflect a different understanding between the parties.
Gaggero argues that these documents (some of them dating back to 1991) properly
record the continuous understanding between the parties that if BCC developed the
property it would share in the gain if the property were to be sold.
We think Gaggero has the better of this argument. We do find that he
concealed BCC from Monticello, but only because he wanted the deal to get done
and not because he was implicitly denying that BCC co-owned the property. The

- 16 [*16] negotiations that led to the sale were long and delicate, but the closing was
quick: Gaggero and Monticello signed the sale agreement on March 21, 1997, and
escrow was over less than a week later. The parties disputed commissions
throughout the deal, and Gaggero ended up indemnifying Monticello for some of the
sales commissions. We specifically find Gaggero credible when he testified that he
feared the introduction of BCC as a part-owner would have jeopardized the sale.
Once Monticello signed its deed, however, Gaggero did ensure that both BCC and
himself as an individual were considered sellers in the escrow, closing-agreement,
and tax-related documents.
The Commissioner would have us rely on a statement by Gaggeros lawyer
in the deal--Jennifer Kilpatrick--that she erroneously assumed the $3 million
payment to BCC was a loan repayment because BCC was the beneficiary of a deed
of trust recorded on the property in January 1996 to secure payment of $7.5
million. On the contrary, we find that Gaggero recorded the deed of trust on the
property in favor of BCC to protect BCCs interests in a number of Gaggeros
properties. We also find that Gaggeros retention of a different lawyer to represent
BCC and BCCs own reconveyance of the deed of trust once it received $3 million
from escrow are persuasive evidence that the parties intended to follow the terms

- 17 [*17] of the Sale Agreement that required Gaggero to transfer part ownership to
BCC.7 We likewise find that Gaggeros retention of separate legal representation
for himself and BCC strongly indicates that he was looking for an arms-length
transaction where each partys own interest was represented. Therefore, we weigh
this factor in favor of Gaggero.
C.

Did BCC acquire equity in the property?

The Commissioner argues that BCCs shared investment risk was not a realproperty interest. He also reminds us that Gaggeros adviser conceded as much
during trial. We agree that BCC--just by signing the contract back in 1991--did not
acquire any significant equity. But once it started work, things quickly changed:
One who contracts to purchase real property acquires an equity therein
immediately on the signing of the contract to purchase and taking possession.
7

According to the Commissioner, Gaggero committed a material misrepresentation of fact for the purpose of avoiding the transfer tax--a misdemeanor under
Los Angeles, Cal., County Code section 4.60.170 (1967)--by not recording a deed
showing a transfer from Gaggero of part ownership to BCC and then later omitting
BCC from the deed to Monticello. Although the Commissioner is correct that the
parties didnt record Gaggeros transfer of part ownership to BCC, we dont believe
Gaggero was hiding BCCs interest for the purpose of avoiding the transfer tax.
Payment of transfer taxes usually happens with recording, see Los Angeles, Cal.,
County Code section 4.60.120, and Gaggero credibly testified that the parties didnt
record BCCs interest because it happened so close to the time of the Monticello
deal. We therefore find that the parties failure to record a deed and to pay the
transfer tax on the transfer of part ownership to BCC arent persuasive evidence of
this factor.

- 18 [*18] This equity increases with every payment. No comparison of the value of the
realty and the amount of rental paid at any given time has any validity. Oesterreich
v. Commissioner, 226 F.2d 798, 803 (9th Cir. 1955). We think this case is a lot like
an installment sale, because BCC was pouring money and effort into the house for
years after 1991. Like a buyer under an installment-sale contract, BCC gradually
increased the value of its conditional interest until it completed the work, which is
when it became fully entitled to an equity right. We need not try to figure out if and
precisely when its conditional interest became an equity interest, but do find that by
February 4, 1997--when it fulfilled the condition that it finish work--it did acquire
equity in the property.
D.

Did BCC control the property?

One of the indicators that an asset has been sold is that control over that asset
shifts to another party. Corliss v. Bowers, 281 U.S. 376, 378 (1930). The
Commissioner argues that this factor weighs against Gaggero because he kept
complete control over the house until he sold it. The Commissioner therefore views
the Sale Agreement as first a construction contract and BCC as merely a
contractor. Gaggero, says the Commissioner, held at all times the full right, power,
and authority to sell and transfer the property as he saw fit.

- 19 [*19] The Commissioner stresses that Gaggero made the house his personal
residence and the Sale Agreement made him responsible for all costs and income
associated with it. The Commissioner also argues that the parties ensured
Gaggeros control over the house would survive any loss of his control over BCC in
the section of the Sales Agreement that bars BCC from making any decisions about
the property without Gaggeros consent. We dont lay too much stress on this,
however, because the Sale Agreement also ended Gaggeros veto power once BCC
finished the development work and received ownership in the house. It also lasted
only while Gaggero was still BCCs president. The latter part of section 3.6 of the
Sale Agreement specifically notes that if Gaggero did not have more than 51%
ownership in BCC or ceased to be its president, then all decisions should be
mutually agreed upon in writing between BCC and Gaggero and all contracts
concerning the property should be signed by both BCC and Gaggero. That section
also states all agreements and documents concerning the house had to be signed by
both BCC and Gaggero after BCCs interest vested. We find it especially telling
that this agreement was devised six years before the Monticello sale, and it is strong
evidence that Gaggero was not certain he would remain in control of BCC, and so
took pains--as he said in testimony that we find credible--to make sure the
agreement was at arms length. We therefore weigh this factor in favor of

- 20 [*20] Gaggeros argument that he sold part ownership of the property to BCC upon
vesting.
E.

Did BCC bear the risk of loss or damage to the property?

The answer to this question is that both Gaggero and BCC assumed some
risk. According to section 3.4 of the Sale Agreement, Gaggero was responsible for
insuring against loss, and BCC had to insure its work on the house and against any
harm that its work might cause third parties. BCC had had twelve years of
experience in the Malibu custom-home market, and the resources to develop the
property to create its highest and best value for sale. Developing property on
Californias coast is not for the risk-averse, and features potential exposure to
litigation with local governments and the California Coastal Commission.8 See,
8

Malibu may be especially difficult for property owners yearning to improve


their land. See, e.g., William S. Banowsky, The Malibu Miracle 275-96 (2010)
(discussing general sentiment of Malibu residents regarding construction of
Pepperdine Universitys campus); id. at 280 (Since the days of silent movies,
Malibu meant serenity, privacy, no more cars on the highway, and no more
construction on the hills.); id. at 293 (Malibu is probably the most sophisticated
place left on the planet without any public sewage disposal system, and thats no
accident. A century of vigilance guaranteed it. Malibuites were among Americas
earliest environmentalists. Fifty years before ecologists became ubiquitous,
Malibuites were national no-growth leaders. The 1950s popularized handwritten
Pacific Coast Highway signs * * * proclaim[ed]: Small is Beautiful! Less is More!
Not in My Backyard! No Sewer Here!). In 2015 for the very first time Malibuites
will be connected to a sewer as a result of state coercion, despite the stink raised by
the locals. See Memorandum of Understanding Between City of Malibu &
(continued...)

- 21 [*21] e.g., Reddell v. Cal. Coastal Commn, 103 Cal. Rptr. 3d 383 (Ct. App. 2009);
Charles A. Pratt Constr. Co. v. Cal. Coastal Commn, 76 Cal. Rptr. 3d 466 (Ct.
App. 2008); LT-WR, LLC v. Cal. Coastal Commn, 60 Cal. Rptr. 3d 417 (Ct. App.
2007). California also imposes liability on developers more generally, see 11 Harry
D. Miller & Marvin B. Starr, California Real Estate, sec. 29:21 (3d ed. 2012), and
Gaggero was concerned about liability risk both while BCC developed the property
and after the sale to Monticello. He wanted to insulate himself from that risk as an
individual, and BCC was already an entity that he used in other development
projects and which, as an established real-estate development corporation, could
insure against liability claims at a lower cost. This division of risk between BCC
and Gaggero is entirely consistent with the behavior of other co-owners of property,
and at the very least is not a factor to weigh against Gaggero.

(...continued)
Regional Water Quality Control Board, Los Angeles Region & State Water
Resources Control Board Regarding Phased Implementation of Basin Plan
Amendment Prohibiting On-Site Wastewater Disposal Systems in the Malibu Civic
Center Area, available at
http://www.malibucity.org/download/index.cfm/fuseaction/download/cid/17478/
(last visited Nov. 19, 2012).

- 22 [*22] F.

Did BCC receive any benefit from the propertys operation or sale?

This is the single most important factor in this determination. As weve


already found, BCC fulfilled its obligations under the Sale Agreement and so earned
millions of dollars in income on paper when its property interest in the Malibu
property vested in February 1997. It was then able to receive $3 million in cash
proceeds from that interest when the property was sold to Monticello. Its earnings
were, moreover, contingent on the markets fluctuations, not the costs it incurred in
developing the property--a key distinction between equity and merely being a
lienholder. See, e.g., Root v. Commissioner, 220 F.2d 240, 241 (9th Cir. 1955)
([T]he essential difference between a creditor and a stockholder is that the latter
intends to make an investment and take the risks of the venture, while the former
seeks a definite obligation, payable in any event) (citation and internal quotation
marks omitted). But the Commissioner nevertheless argues that BCC did not share
the benefits of ownership during the development years, and contends that this is an
indication that it had only a lien and not an equity interest.
The Commissioner is partly right: Section 3.4 of the Sale Agreement, for
example, states that Gaggero was entitled to any income generated by the
property, such as movie location income, or event income. BCC also had no
right to charge rent for the property because Gaggero had the right to maintain his

- 23 [*23] personal residence on the property, and it was Gaggero alone who was
entitled to all the income-tax benefits relating to the property. Gaggero even agreed
with the Commissioner on this front, and explained that since he occupied the
property as his residence he paid the expenses and enjoyed the benefits.
We think, however, that we need to swing the light this factor shines away
from the development phase and over to BCCs rights once it finished its work. The
Commissioner argues that even after BCCs right in the property vested it had only
an interest in the proceeds from the sale of the house, and that under Suhr v.
Commissioner, T.C. Memo. 2001-28, 2001 WL 103451, at *3, an interest in those
proceeds is not an ownership interest in the real property. The problem is that Suhr
was about whether a taxpayer had an ownership interest in his former wifes house
simply by virtue of his divorce decree, which gave him one-half of the proceeds
from the sale of the house. This case does not involve a marital interest in proceeds.
The other problem with the Commissioners argument is that the Sale
Agreement provided that BCCs ownership interest would vest when it completed
its services, and there was very little time between that date and the sale to
Monticello. The Commissioner is right that the Sale Agreement gave Gaggero the
operating income from the property; but on the facts of this case--where the

- 24 [*24] property wasnt a mall or office building, but only a private residence--we
find that BCCs variable return on proceeds from a sale to a third-party is more
salient than its lack of a right to share in foreseeably tiny operating income. This
factor weighs especially heavy in Gaggeros favor.
G.

Did Gaggero have an obligation to deliver a deed in return for


payments?

The Commissioner argues that Gaggero had no obligation to deliver a deed to


BCC. The Sale Agreement does define Deed as a grant deed conveying title to
the Property from [Gaggero] to [BCC], and does say that either party may record
a Deed against the property upon completion of BCCs services or the sale of the
property. But we read this part of the Sale Agreement as making the recording of
the deed, not Gaggeros obligation to execute one, optional with either party.
Section 7.6 of the Sale Agreement specifically provides that [i]n addition to any
documents expressly referred to in this Agreement to be executed by any or all
parties, all parties agree to execute any and all documents which might be required
to implement the provisions of this Agreement.
The Commissioner also argues that BCC had no obligation to make
payments on the debts Gaggero incurred to improve the property. But whether
BCC made payments on debts incurred before its part-ownership interest vested is

- 25 [*25] irrelevant to this factor, which asks whether BCC made payments in return
for its part-ownership interest. The Sale Agreement specified that BCCs purchase
price was its services, which BCC did provide in exchange for its interest.
This factor also weighs in Gaggeros favor.
H.

Did BCC have a vested right of possession?

The Commissioner notes that BCC had no right to rent the house and did not
have any right to even possess the house. This is not terribly important in a case
like this one, because Gaggero is not arguing that he sold the property to BCC--hes
arguing that he sold part-ownership to BCC. If he was arguing that he sold the
entire property to BCC and still got to live there rent-free with the right to rent to
another, that would certainly be a factor that counted against calling the deal a sale.
But that he was conveying an immediate right to BCC to work on the property, and
a promise to give it an interest when the work was done looks entirely consistent
with his own characterization of the deal as an executory sale of a partial interest. If
the Commissioners argument is to be believed, BCCs interest in the property was
nothing more than a lien because its only real value was the expectancy of payment
on a sale to a third party.
The Commissioner is, again, partly right. He is right that what the parties
called fee ownership during the development period was a mere contractual

- 26 [*26] right. During development the Sale Agreement gave BCC no right to occupy
or to collect rent from the property. But the situation all changed when BCC
finished its work. At that moment, BCC could transfer, take possession, or partition
the property, and there is nothing in the Sale Agreement that could keep it from
doing so. We therefore find that--after vesting--BCC could have done as it liked
with its share of the property.
The Commissioner also views the fact that BCC relinquished authority over
the property to Gaggero as an indicator that BCC didnt have true ownership. We
disagree. BCC resolved on February 8, 1997, once its ownership interest had
vested, that it would grant Gaggero power to act on its behalf to sell the property.
Nevertheless, if a person other than Gaggero owned BCC, the Sale Agreement
allowed BCC to transfer, dispose or even exercise its right to partition the house
under California law. See Cal. Civ. Proc. Code sec. 872.710(b) (West 1980); see
also Am. Med. Intl Inc. v. Feller, 131 Cal. Rptr. 270, 273 (Ct. App. 1976).
Although a right to partition is not by itself sufficient proof of ownership, Schwartz
v. Shapiro, 40 Cal. Rptr. 189, 199 (Ct. App. 1964), we think it undermines the
Commissioners characterization of BCC as a mere lienholder.
This is also a factor weighing in Gaggeros favor.

- 27 [*27] I.

Which party pays the property taxes?

The Sale Agreement states in section 3.4 that Gaggero is responsible for all
costs associated with the property, including the obligation to pay property taxes
while BCC was developing the property. And Gaggero admitted that he himself
paid property taxes. Gaggero argues, however, that property taxes are not that
relevant in this case. We agree. There was so little time between BCCs
completion of its work and the sale to Monticello that neither BCC nor Gaggero had
to pay property taxes during that timeframe.
J.

Conclusion

We find that BCC was a co-owner of the property before the sale to
Monticello. On completion of its development work, BCC had a share of the
benefits and burdens in the property and received part-ownership in the property.
We accept Gaggeros explanation that disclosure of BCCs interest to Monticello
would have jeopardized the sale of the property, but note that both Gaggero and
BCC filed separate real-estate reporting solicitation forms to the escrow agent,
showing that there were multiple transferors. Both Gaggero and BCC were paid
directly from the escrow for their respective ownership interests. And the $9.6
million sale proceeds was allocated according to the Sale Agreement--$6.6 million
to Gaggero, and $3 million to BCC.

- 28 [*28] II.

The Sale to BCC Followed by the Sale to Monticello

After concluding that Gaggero sold a partial interest in the property to BCC
when its interest vested in February 1997, we now turn to the question of what, if
any, capital gains Gaggero should have recognized from the transactions at issue
here. As we noted earlier, the fact that Gaggero sold a partial interest in the
property to BCC doesnt necessarily mean the Commissioner loses. The
Commissioner has an alternative theory that Gaggeros sale of a partial ownership
should trigger recognition of capital gain. BCC, we have found, completed the
development services it had contracted to perform in February 1997, and its
ownership interest vested at that time. The Commissioner insists that if Gaggero
truly believed he had sold something to BCC, he needed to report that sale on his
tax return. Gaggero even said that Walters (his tax preparer) told him--as they were
preparing for trial--that he shouldve told Gaggero to report a capital gain both from
the disposition to BCC, and then again when the property was sold to Monticello.
Gaggero argues, however, that this was a harmless mistake because both
Gaggero and BCC picked up the full capital gain in the same year at the same
time--Gaggero reported $6.6 million and BCC reported $3 million. And if no
income was left unreported, disaggregating the large capital gain on the sale to

- 29 [*29] Monticello into two smaller ones would have no practical consequence on
Gaggeros tax bill.
A closer look, however, reveals that Gaggero did indeed leave a slab of
gain unreported on his return. Even if BCC reported $3 million of income in
connection with the Monticello sale,9 whats still missing is any reporting of
the transfer from Gaggero to BCC. Gaggero seems to want the benefits of
characterizing the February 1997 vesting as a sale to BCC (so he could report
only a $6.6 million sales price from the Monticello transaction) without the

Although BCCs 1997 tax return is not before us, we think that the $3
million that Gaggero argues that BCC reported as income from its interest in the
Malibu property was realized when its interest vested on February 7, 1997, and not
when the property was sold to Monticello the following month. Indeed, BCC
reported only ordinary income--and no capital gain--on its tax return that year.
Reporting the $3 million as ordinary income when its interest vested would be in
accord with section 1.61-2(d)(1), Income Tax Regs., which says the fair market
value of property acquired in exchange for services must be included as ordinary
income by the party rendering the services. See also Weigl v. Commissioner, 84
T.C. 1192, 1231 (1985). That value would then become BCCs basis in the
property. See Williams v. Commissioner, 37 T.C. 1099, 1106 (1962); Estate of
Rogers v. Commissioner, T.C. Memo. 1970-192, 1970 WL 1737, affd, 445 F.2d
1020 (2d Cir. 1971). Assuming that BCCs services were valued at $3 million as of
February 4, 1997 (well get to that dispute momentarily), when BCC received its
partial interest in exchange for its services, it acquired a basis of $3 million in that
partial interest. When BCC sold its partial interest to Monticello on March 27,
1997 and received $3 million in proceeds, it would not have had to report any
capital gain since its amount realized and adjusted basis both would have been $3
million.

- 30 [*30] corresponding burden of the gain that might arise from the BCC sale. In
short, Gaggero should have reported that sale.
We now must determine his gain from that sale. To do that, we must
calculate both Gaggeros amount realized and his adjusted basis in the interest sold.
First, we tackle the amount realized.
We start with the Code. Gain realized from the sale or other disposition of
property is taxed under section 61(a)(3). The amount of gain realized is the excess
of the amount realized over the adjusted basis. Sec. 1001(a). Section 1001 also
tells us that the amount that Gaggero realized in disposing of a part-ownership of the
house is the sum of the cash and the value of any property received.
The problem here is that BCC didnt give Gaggero cash or property in
exchange for its interest; it gave its services in exchange for one-half of the
increase in market value of the property which its work created (or at least
contributed to). This should be equal to what BCC received. A party transferring
property in exchange for services realizes gain to the extent the fair market value
of the property transferred exceeds his adjusted basis in the property. See United
States v. Davis, 370 U.S. 65, 71-72 (1962) (transferring appreciated property to
pay compensation is a taxable disposition of property for its fair market value);

- 31 [*31] Riley v. Commissioner, 37 T.C. 932, 937 (1962), affd, 328 F.2d 428 (5th
Cir. 1964).
The Commissioner argues that if BCC made $3 million worth of
improvements to the Malibu property (since that was the amount BCC received
from the Monticello sale), then Gaggero conveyed an interest in the Malibu property
worth $3 million to BCC in exchange for its services. Therefore, the Commissioner
argues, Gaggeros amount realized should equal $3 million with respect to that
conveyance.
Gaggero argues that the fair market value of the property when he transferred
the part-ownership to BCC has to be determined by an appraisal of the property
at the time BCCs interest vested. According to Gaggero, any post-valuation date
event would not be considered probative of the fair market value of the property
transferred earlier. The trouble is that we have an appraisal of $6 million dated
February 22, 1996 (almost a year before the work was finished), and an appraisal
from March 10, 1997 (about a month after BCC finished its work and less than a
month before the Monticello sale) that valued the sum of the two Malibu lots
that Gaggero owned at $10 million. We dont have an appraisal of only the parcel
at issue here as of February 4, 1997, the day BCCs interest vested. Gaggero
and Walters, however, estimated the value of that parcel as of that date to

- 32 [*32] be $6,600,000, which they calculated by taking 66% of the March 1997
appraisal of the combined values of both parcels ($10 million), which were both
sold to Monticello at about the same time for a total of $14.5 million.10 Based on a
$6.6 million valuation, to obtain the amount realized on the transfer to BCC,
Gaggero and Walters put forth--on the assumption that we find that there was a sale
to BCC--the following calculations: First, subtract $3 million that was reserved to
Gaggero pursuant to the Sale Agreement, which reduces the amount to $3.6 million.
Then, multiply the $3.6 million by the 50% interest that BCC was to receive
according to the Sale Agreement.11 Thus, say Gaggero and Walters, if there was a
sale to BCC, Gaggeros amount realized from that sale should be $1.8 million.
We find that the Commissioner has the better position here. We
acknowledge that the fair market value of the Malibu property on February 4, 1997
(when BCCs interest vested) wouldnt necessarily equal the $9.6 million

10

The other Malibu lot sold for $4.9 million; therefore the sale proceeds from
the Malibu property at issue here ($9.6 million) represent approximately 66-percent
of total sale proceeds of $14.5 million.
11

Specifically, the Sale Agreement provided that [u]pon the sale or transfer
of the Property, Buyers fifty percent (50%) interest shall be calculated on the gross
value of the entire property, less * * * real estate brokers commissions, legal fees, or
other costs of sale agreed to between the parties, and less the sum of $3,000,000.

- 33 [*33] sales price agreed upon for that property on March 21, 1997 (which resulted
in the $3 million sales price allocation to BCC at closing on March 27, 1997).12 We
do, however, find that the amount allocated to BCC from the Monticello sale in
March 1997 is highly probative of the fair market value of BCCs interest less than
two months earlier. See Polack v. Commissioner, 366 F.3d 608, 612 (8th Cir.
2004) ([S]ubsequent events that shed light on what a willing buyer would have
paid on the date in question are admissible, such as evidence of actual sales prices
received for property after the date in question, so long as the sale occurred within a
reasonable time * * * and no intervening events drastically changed the value of the
property (citation and internal quotation marks omitted)), affg T.C. Memo. 2002145, 2002 WL 1284877; Estate of Noble v. Commissioner, T.C. Memo. 2005-2,
2005 WL 23303, at *10 (An event occurring after a valuation date, even if
unforeseeable as of the valuation date, * * * may be probative of the earlier
12

According to Gaggero, BCCs $3 million allocation from the Monticello


closing resulted from the following calculations: (1) gross sales price of $9.6
million; (2) minus $600,000 that Gaggero estimated were the costs of the sale (he
approximated $500,000 in commissions and $100,000 in other closing costs), which
he allocated all to himself since he said he personally indemnified Monticello
against those costs; (3) minus $3 million--the first money out according to
Gaggero--pursuant to the Sale Agreement. This leaves $6 million and, under the
Sale Agreement, Gaggero and BCC should divide that amount 50/50. (The
$600,000 in estimated sales costs, we find, definitely affected the amount BCC
received which we do find equaled $3 million. They were not substantiated,
however. See infra p. 40 at note 14.)

- 34 [*34] valuation to the extent that it is relevant to establishing the amount that a
hypothetical willing buyer would have paid a hypothetical willing seller * * * as of
the valuation date). This is especially true here, where the subsequent event--the
Monticello sale--was reasonably foreseeable as of the valuation date; Monticello
had made an offer to Gaggero before the time that BCCs interest vested. Indeed,
we give the actual sales price allocated to BCC considerably more weight than the
March 10, 1997 appraisal (which undervalued the properties by approximately $4.6
million) that Gaggero and Walters rely on to calculate their estimate of the amount
Gaggero realized. Without any credible evidence to the contrary, we therefore find
that the value of BCCs interest on February 4, 1997 was equal to the $3 million
sales price that BCC received around March 27, 1997. Accordingly, we find that
Gaggeros amount realized from the conveyance to BCC on February 4, 1997 was
$3 million.
After determining amount realized, we now have to figure out Gaggeros
adjusted basis in that partial interest at the time of the sale before we can calculate
his realized gain. Real propertys basis is usually its cost. Sec. 1012; sec. 1.10121(a), Income Tax Regs. The parties dont dispute that Gaggeros basis in the
property before entering into the agreement with BCC was $689,000. But a
taxpayer increases his adjusted basis by the cost of improvements that he made.

- 35 [*35] Sec. 1016(a)(1); sec. 1.1016-2(a), Income Tax Regs. The parties stipulated
that by the time the property was sold to Monticello, Gaggeros basis had increased
to $2,167,000.13 We need to allocate a portion of that basis to calculate Gaggeros
realized gain on the interest he transferred to BCC. See sec. 1001; sec. 1.61-6(a),
Income Tax Regs.; Sam Goldberger, Inc. v. Commissioner, 88 T.C. 1532, 1560
(1987); Hall v. Commissioner, T.C. Memo. 1993-198, 1993 WL 142899, at *5.
Not surprisingly, the parties have significantly different views on the proper
allocation of basis to Gaggero for the BCC sale. The Commissioner takes a
hard-line approach. He argues that Gaggeros adjusted basis in the interest
transferred to BCC should be zero because Gaggero didnt adequately substantiate
his payment for the improvements. In contrast, Gaggero argues that--should we
determine that he shouldve separately reported the transfer of the BCC interest--we
should equitably allocate his $2,167,000 adjusted basis. Gaggero and Walters

13

We agree with the parties that the fair market value of BCCs services to
improve the property--which the Commissioner under his alternative theory
acknowledges would be $3 million--should not be added to Gaggeros adjusted
basis. See Hall v. Commissioner, T.C. Memo. 1993-198, 1993 WL 142899, at *4
(determining that--after taxpayers sold a carpenter a 30% interest in a property in
exchange for services the carpenter had rendered--there [was] no legal support for
adding the fair market value of the carpenters services to the [taxpayers] basis in
the property).

- 36 [*36] contend that we should first divide $1.8 million (the proposed amount
realized) by $6.6 million (the proposed valuation of the property as of February 4,
2007), which results in a ratio of approximately 27.3%. From there, Gaggero and
Walters assert that we should multiply that ratio by the adjusted basis of $2.167
million, which amounts to $591,591. That number, they say, should be Gaggeros
adjusted basis.
We agree with Gaggero to the extent he argues that he should be allocated
some basis for the sale to BCC. We also agree that the starting point should be the
$2.167 million adjusted basis. We disagree, however, with the other amounts he
uses for his calculation. What fraction of the $2.167 million should Gaggero have
allocated to the BCC sale? Since we allocated $3 million of the eventual $9.6
million Monticello sales price to Gaggeros amount realized for the BCC sale, we
will use that same percentage to allocate to Gaggeros adjusted basis. The $3
million amount is 31.25% of $9.6 million. We then multiply 31.25% by $2.167
million, equaling $677,188--which we find is Gaggeros adjusted basis in the BCC
sale. Having already found Gaggeros amount realized to be $3 million, that leaves
him with a realized gain on his disposition to BCC of $2,322,812. So that leaves us
with the start of a table:

- 37 -

Date

Amount
realized

Sale #1
(Gaggero to
BCC)

2/4/97

$3,000,000

Sale #2
(Gaggero to
Monticello)

3/27/97

[*37] Sale

Adjusted
basis
$677,188

Realized
gain

Subject to
sec. 1034?

$2,322,812

We still need to attach a few more legs to it before we apply the polish of the
nonrecognition provisions of section 1034. We turn to the March 1997 sale to
Monticello. We know the sales price Monticello paid: It was $9.6 million, $3
million of which was allocated to BCC. That leaves Gaggero with an amount
realized of $6.6 million.14 Having already determined how much of Gaggeros
14

Of the $6.6 million, Gaggero testified--when discussing the calculation of


the $3 million allocation to BCC from the Monticello sale--that he estimated there
were $600,000 of costs in connection with that sale ($500,000 in commissions and
$100,000 in other closing costs). A taxpayer may of course reduce his amount
realized by costs and expenses of the propertys disposition. See, e.g., sec.
1.263(a)-2(c), Income Tax Regs.; Ward v. Commissioner, 224 F.2d 547, 554-55
(9th Cir. 1955), affg 20 T.C. 332 (1953); see also sec. 1.1034-1(b)(4)(i), Income
Tax Regs. Gaggero doesnt argue, however, that any such costs should lower his
amount realized. Indeed, on his 1997 Form 2119, Gaggero reported $6.6 million as
the sales price, but didnt report any amount in the line titled Expense of Sale.
Therefore--in this instance--we take him at his word and dont reduce the $6.6
million by any closing costs. (We think it possible, but need not decide, that the
number was Gaggeros estimate of what it would take to settle a foreseeable dispute
over commissions with a real-estate broker who was hovering near the deal.
Gaggero testified that a lawsuit about this commission spanned many, many
(continued...)

- 38 [*38] adjusted basis to allocate to the BCC sale, its a bit easier to calculate that
number for the Monticello sale (since theres no evidence of any increases to the
basis between the time of the BCC sale and the Monticello sale). Using the
adjusted basis amount of $2.167 million at the time of the BCC sale, and subtracting
the $677,188 basis allocated to that sale, leaves Gaggero with an adjusted basis of
$1,489,812. A $6.6 million amount realized results in a gain to Gaggero of
$5,110,188. So now we have Gaggeros total realized gain from both sales.

Date

Amount
realized

Sale #1
(Gaggero to
BCC)

2/4/97

$3,000,000

$677,188

$2,322,812

Sale #2
(Gaggero to
Monticello)

3/27/97

6,600,000

1,489,812

5,110,188

9,600,000

2,167,000

7,433,000

Sale

Total

14

Adjusted
basis

Realized
gain

Subject to
sec. 1034?

(...continued)
years. and Walters testified that a settlement wasnt reached until long after 1999.
A cash-basis taxpayer in this position of uncertainty is allowed a deduction (as a
capital loss) in the later year when he actually pays it out. See Estate of
Shannonhouse v. Commissioner, 21 T.C. 422, 424 (1953).)

- 39 [*39] III.

Application of Section 1034 to the Sales

Now knowing what Gaggeros realized gain is from those two transactions,
we move on to determine how much of that gain should be recognized. A realized
gain is recognized unless one of the Codes nonrecognition provisions applies. Sec.
1001(c); Cottage Sav. Assn v. Commissioner, 499 U.S. 554, 566 (1991).
Specifically, we need to address the not-so-straightforward question of whether we
look to one or both of the sales transactions in determining how much realized gain
qualifies for nonrecognition under section 1034. To address that question, we start
with the language of the statute and its background.
Before its repeal midway through 1997,15 section 1034 said:
If property (in this section called old residence) used by the taxpayer
as his principal residence is sold by him and, within a period beginning
2 years before the date of such sale and ending 2 years after such date,
property (in this section called new residence) is purchased and used
by the taxpayer as his principal residence, gain (if any) from such sale
shall be recognized only to the extent that the taxpayers adjusted sales
price * * * of the old residence exceeds the taxpayers cost of
purchasing the new residence.
Sec. 1034(a) (before the Taxpayer Relief Act of 1997 (TRA 1997), Pub. L. No.
105-34, sec. 312(b), 111 Stat. at 839) (emphasis added). Thus, assuming a
15

The repeal of section 1034 applied to sales and exchanges made after May
6, 1997, with special rules for sales on or before August 5, 1997. TRA 1997, sec.
312(b), (d), 111 Stat. at 839, 841. Since both parties agree that no sale occurred
after May 6, 1997, section 1034 applies.

- 40 [*40] taxpayer bought a new principal residence within the statutory timeframe,
section 1034(a) provides that a taxpayer should completely defer recognition of gain
on the sale of his principal residence if the adjusted sales price16 of that old
residence did not exceed the cost of purchasing the new residence. See sec.
1034(a); sec. 1.1034-1(a), Income Tax Regs.; see also Bartley v. Commissioner,
T.C. Memo. 1998-322, 1998 WL 596446, at *2 (noting that section 1034 is
mandatory, so that a taxpayer cant elect to have gain recognized where section
1034 is applicable). If the adjusted sales price of the old residence exceeded
the cost of the new residence, however, the taxpayer would recognize gain on the
sale of the old residence--but only to the extent the adjusted sales price of the
old residence exceeded the cost of the new residence. See sec. 1034(a) and
(b); sec. 1.1034-1(a), Income Tax Regs.
Now for a brief bit of history on that statute. Congress amended section 112
(the predecessor to section 1034) through the Revenue Act of 1951, Pub. L. No.

16

The Code defines the term adjusted sales price as the amount realized on
the sale of an old residence reduced by certain nondeductible expenses related to
fixing up the residence in preparation for sale that arent already taken into account
in computing the amount realized. Sec. 1034(b). Since Gaggero hasnt argued that
any of these additional expenses exist, theres no difference between amount
realized and adjusted sales price in this case.

- 41 [*41] 82-183, sec. 318, 65 Stat. at 494.17 See also Clapham v. Commissioner, 63
T.C. 505, 511 (1975). Congress enacted the nonrecognition provisions in that
section because it was aware that the disposition of one residence and the
acquisition of another one were often prompted by a change in the size of a
taxpayers family, a change in the taxpayers place of employment, or other
circumstances beyond the taxpayers control. See S. Rept. No. 82-781, at 34-36
(1951), 1951 U.S.C.C.A.N. 1969, 2004-2006. Although Congress was primarily
concerned with addressing relief from those situations, it also recognized that it
would be administratively burdensome to confine the sections application to those
circumstances, and thus extended relief to all residential sales that met the
requirements. See id.
While both parties agree that section 1034 applies here, they disagree about
how to apply it. Although neither party specifically says as much, the dispute
arises from what the term old residence means under section 1034(a). By the
manner on which he reported the Monticello sale on his 1997 return, Gaggero took

17

The only significant change between the nonrecognition rules in 1951 and
1997 was the extension of the period for acquisition or construction of a new
residence from one year to eighteen months by the Tax Reduction Act of 1975, Pub.
L. No. 94-12, sec. 207(a), 89 Stat. at 32, and then to two years by the Economic
Recovery Tax Act of 1981, Pub. L. No. 97-34, sec. 122(b), 95 Stat. at 197. See
Bartley v. Commissioner, T.C. Memo. 1998-322, 1998 WL 596446, at *4.

- 42 [*42] the position that his old residence for purposes of applying section 1034
was only the partial interest in the property he retained after the sale to BCC in
February 1997 ($6.6 million). Under that logic, Gaggero believed that his entire
claimed realized gain (claimed amount realized ($6.6 million) less claimed basis
($2.167 million)) qualified for nonrecognition under section 1034 because his new
residence, which the IRS has acknowledged cost $6.7 million, exceeded the
adjusted sales price of what he claimed was his old residence.
On the other hand, under his first theory (arguing no sale to BCC), the
Commissioner asserts that the adjusted sales price of the old residence for
purposes of section 1034 was $9.6 million. Under that calculation, since the
adjusted sales price of Gaggeros old residence exceeded the cost of his new
residence by $2.9 million, the Commissioner says that Gaggero should recognize a
$2.9 million gain. Alternatively--even assuming there were a sale to BCC and then
a sale to Monticello--the Commissioner says that we should adopt Gaggeros view
that the transactions were simultaneous event[s], which the Commissioner says
gets him to the same place as his primary position. He argues that we should
view the $3 million sale to BCC and the $6.6 million sale to Monticello as
simultaneous sales--where both sales prices would be included for determining
nonrecognition under section 1034. The Commissioner contends, in other words,

- 43 [*43] that allowing Gaggero to use his sale to BCC as a means [to] lower[] his
receipts from the sale to Monticello, does not fall within the intended scope of
[section] 1034; and would only encourage a taxpayer to strip away part of his
interest in his residence in order to fully take advantage of its provisions.
Who has the better position on what should be the adjusted sales price of
the old residence? We first look to the regulations, since the statute doesnt
define the term old residence. Under the regulations, an old residence is
defined as property used by the taxpayer as his principal residence which is the
subject of a sale by him after December 31, 1953. Sec. 1.1034-1(b)(1), Income
Tax Regs. The use of the phrase a sale doesnt definitively answer the question
of whether an old residence could be disposed of via multiple sales, but it also
doesnt foreclose the possibility. Although weve found very little authority to
help us answer this question, we agree with the Commissioner that both the BCC
and Monticello sales prices should be considered in determining the amount of
gain that qualifies for nonrecognition under section 1034. We dont hold this
because the sales were simultaneous but because both sales--although not
simultaneous--were of Gaggeros old residence. Congress enacted section 1034
(and its predecessor, section 112) to lift the tax burden that a taxpayer faced when
he decided to move from a less expensive home to a more expensive one. That

- 44 [*44] just isnt the case here. Gaggero moved from a home that was sold for $9.6
million to a home that cost him $6.7 million. Although were not suggesting that
either Gaggero or Walters engaged in any funny business in structuring the sales
transaction to reap the benefits of section 1034, we dont believe Congress intended
for a taxpayer to have the ability to manipulate the sales price of his old residence
by selling it in different pieces, thereby allowing him to take advantage of section
1034s nonrecognition provisions.
There is one tiny bit of authority out there that supports our interpretation of
the term old residence. In Bogley v. Commissioner, 263 F.2d 746 (4th Cir.
1959), revg 30 T.C. 452 (1958), taxpayers acquired thirteen acres of land in 1939,
constructed a residence on that land, and lived in that residence until December 1,
1950 when they moved to a new residence several miles away. Id. at 746-47.
Before December 31, 1950, they sold the old home and three of the thirteen acres.
Id. at 747. The following year, the taxpayers sold the other ten acres in two
separate transactions. Id. The nonrecognition provisions of section 112 (added by
the Revenue Act of 1951), however, applied only to residences that were sold after
December 31, 1950. See id. Since the taxpayers sold the house and the three acres
in December 1950 before section 112 became effective, they reported and paid
capital gain tax on the difference between the sales price and their cost basis.

- 45 [*45] Id. However, when the taxpayers sold the remaining ten acres in 1951 (after
the enactment of section 112), they didnt report the proceeds of those sales because
they claimed that those ten acres were part of their old residence within the
meaning of section 112. Id.
Although we had concluded that those ten acres werent a part of the
taxpayers old residence, Bogley, 30 T.C. at 454, and thus held they couldnt
avail themselves of section 112s nonrecognition provisions, the Fourth Circuit
reversed. It couldnt agree with such a narrow reading of the statute,
determining the statute [did] not require the character of the [ten acres of
unimproved land] to be determined in vacuo, ignoring what had gone before.
Bogley, 263 F.2d at 747-48. Instead, the Fourth Circuit deemed that [t]he
thirteen acres intact were undoubtedly the taxpayers old residence. Id. at 748.
It went on to explain that [t]here is no limitation in the statute, even by
implication, that the old residence property must be sold in its entirety. Id. As
the character of the ten acres never changed * * * it was in reality part of the
taxpayers old residence.18 Id. And since the taxpayers sold the ten acres
18

We note that the question in Bogley centered on what was the old
residence, but also acknowledge that the Fourth Circuit didnt specifically address
whether the adjusted sales price (actually called the selling price under section
112) of the taxpayers old residence should have included the amount realized
(continued...)

- 46 [*46] within the statutory timeframe, the court concluded that they were entitled to
the benefit of section 112s nonrecognition provisions. Id.
Although a revenue ruling doesnt bind us, see Taproot Admin. Servs., Inc.
v. Commissioner, 133 T.C. 202, 208-09 (2009), affd, 679 F.3d 1109 (9th Cir.
2012), one such ruling touching on a Bogley-like situation is also helpful here.
In Rev. Rul. 76-541, 1976-2 C.B. 246, a taxpayer owned a principal
residence on a ten-acre plot. He then sold off pieces of that property at various
times. He first sold the house and three (of the ten) acres immediately surrounding
the house together. Later that year, he sold two of the other seven acres to
another purchaser. The taxpayer began construction of a new residence on the
remaining five-acre portion before the sale of the two-acre plot, but didnt move
into it until afterward. He realized a gain from each of the sales transactions,
but combined the gain from the sale of the old residence and three acres of
land (the first sale) with the gain from the sale of the two-acre parcel (the

18

(...continued)
from the 1950 sale for purposes of determining what part of the 1951 gain qualified
for nonrecognition. In other words, the Bogley court only determined that the latter
two sales were entitled to the benefit of the nonrecognition provisions of section
112. It didnt explicitly say how much of the gain from those two sales qualified for
nonrecognition under that section.

- 47 [*47] second sale) and treated the combined gain as gain from the sale of the old
residence under section 1034.19
Relying on Bogley, the IRS ruled that the taxpayers sale of the house and
three-acre portion before his sale of the two of the remaining seven acres did not
alter the character of the two acres. The IRS determined that the two-acre parcel
remained part of the taxpayers old residence for purposes of section 1034, and
ruled that the nonrecognition provisions of section 1034 applied not only to the gain
realized from the sale of the three-acre parcel containing the taxpayers principal
residence, but also to the gain realized from the subsequent sale of the two-acre
parcel.20
We now turn back to the facts here. The first thing to note is that the facts in
Bogley and Rev. Rul. 76-541 featured subsequent sales only of acreage without a
structure, and not a subsequent sale of a partial interest in the structure itself. This
is actually helpful in finding a solution to the present puzzle, because Bogley
19

Since the cost of the taxpayers new residence exceeded the total
adjusted sales price of all of the property sales combined, the taxpayer reported
that recognition of the combined gain from those sales should be deferred under
section 1034.
20

Although this ruling, like Bogley, didnt specifically say that the adjusted
sales price of the old residence should have included the amount realized from
all of the sales combined for purposes of determining what portion of the realized
gains qualified for nonrecognition under section 1034, by ruling in the taxpayers
favor, it implicitly endorsed that notion.

- 48 [*48] led to a T.C. Opinion, and though it was reversed on appeal, the appeal was to
a different circuit than the one this case would presumably go to. As a reviewed
Opinion, Bogley remains good law in our Court unless a case is to be appealed to
the Fourth Circuit; this case is not. See Golsen v. Commissioner, 54 T.C. 742, 757
(1970), affd, 445 F.2d 985 (10th Cir. 1971). That means that we have to follow the
rule we ourselves laid down in Bogley, and not what the Fourth Circuit ruled.
Except that our holding in Bogley was that unimproved land upon which
[the taxpayers] did not reside was not their old residence. See 30 T.C. at 454.
That holding isnt applicable to the facts of Gaggeros case. Here we have two
partial sales of an actual structure in which Gaggero resided. Our holding in
Bogley is distinguishable, and we do distinguish it to fit these facts. We also
recognize that the taxpayers in Bogley and Rev. Rul. 76-541 (arguing for a
subsequent sale to be characterized as part of the old residence) sought the
opposite result that Gaggero does here (arguing that a prior sale should not be
characterized as part of the old residence). Nonetheless, we find the underlying
principle from Bogley and Rev. Rul. 76-541--that the nonrecognition provisions of
section 1034 (and its predecessor) can apply to more than one sale if a primary
residence is sold in parts--persuasive in the situation we are presented with in this

- 49 [*49] case. The fact that Gaggero sold a partial interest in his primary residence to
BCC before selling the rest of his interest in Monticello approximately six weeks
later didnt alter the character of the preceding interest sold to BCC. We therefore
conclude that the entire Malibu property--including the interest Gaggero sold to
BCC--was undoubtedly Gaggeros old residence for section 1034 purposes as
both sales of the property were sold within two years of Gaggero purchasing his
new residence. Bogley, 263 F.2d at 748. To conclude otherwise would be an
impermissible narrow reading of the statute. Id. at 747. Section 1034 doesnt
require the character of the partial interest sold to BCC to be determined in vacuo,
ignoring what took place six weeks later (and in the same taxable year). Id. at 748.
Since neither the character of the partial interest Gaggero sold to BCC nor the
character of the remainder of that interest he sold to Monticello ever changed, we
believe they were both in reality part of Gaggeros old residence. Id.
Therefore, since both transfers were of Gaggeros old residence, we conclude that
for purposes of the nonrecognition provisions of section 1034 both the sale to BCC
and the sale to Monticello ($6.6 million) should be included to calculate the
adjusted sales price of that old residence.21
21

We do not believe that concluding that there were two separate sales for
the purposes of determining realized gain precludes us from also concluding that
(continued...)

- 50 [*50]

Our table is finished:

Date

Amount
realized

Sale #1
(Gaggero to
BCC)

2/4/97

$3,000,000

$677,188

$2,322,812

Yes

Sale #2
(Gaggero to
Monticello)

3/27/97

6,600,000

1,489,812

5,110,188

Yes

9,600,000

2,167,000

7,433,000

Sale

Total

Adjusted
basis

Realized
gain

Subject to
sec. 1034?

All thats left is one more bit of math. Gaggeros adjusted sales price in his
old residence ($9.6 million) exceeded the cost of his new residence ($6.7 million).
Gaggero should have recognized a gain in 1997 of the difference, equal to $2.9
million.
IV.

Penalties
The Commissioner imposed penalties under section 6662 based on a

substantial understatement of tax because Gaggeros 1997s tax return reported no


tax due and the determined deficiency totaled more than $180,000.

21

(...continued)
sales price from both of those sales are part of Gaggeros old residence for
purposes of applying the provisions of section 1034. The former issue is one of
realization of gain, the latter asks how much of that realized gain should be
recognized.

- 51 [*51] Penalties under section 6662 are subject to the defense of reasonable, goodfaith reliance on professional advice. Sec. 6664(c)(1); see also sec. 1.6664-4(a),
Income Tax Regs.; Higbee v. Commissioner, 116 T.C. 438, 448 [*51] (2001).
Whether the taxpayer acted with reasonable cause and in good faith depends upon
all the pertinent facts and circumstances. See sec. 1.6664-4(b)(1), Income Tax
Regs. Generally, a taxpayer must show that: (1) the adviser was a competent
professional who had sufficient expertise to justify reliance; (2) the taxpayer
provided necessary and accurate information to the adviser; and (3) the taxpayer
actually relied in good faith on the advisers judgment. See Neonatology Assocs.,
P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd, 299 F.3d 221 (3d Cir. 2002);
see also Estate of La Meres v. Commissioner, 98 T.C. 294, 315-16 (1992).
Gaggero argues that he reasonably relied in good faith on Walters all the way
from the structuring of the Sale Agreement with BCC through the reporting of
the sale to Monticello on his tax return. We find by an abundance of evidence that
Gaggero did rely on Walters. We also find that Walters would appear to someone
of Gaggeros experience and education--and actually was from any objective
viewpoint--a thoroughly qualified professional adviser. Walters has been a CPA
since 1978 and has been with the firm of Kellogg & Andelson since 1975. K&A
is ranked 18th among accounting firms in Southern California, has been in

- 52 [*52] business since 1939, and has approximately 100 employees. Both K&A and
Walters had experience with real-property transfers when K&A drafted the Sale
Agreement and Development Contract. K&A and Walters had extensive experience
with these type of owner-developer real-estate transactions--they have put them
together, drafted the necessary agreements, and prepared the tax returns on which
these deals are reported. Many of K&As other clients are real-estate developers
and owners. Gaggero had been a client of K&A since 1984 and K&A has done all
of Gaggeros and BCCs tax work since that then. We also find that Gaggero
provided Walters and K&A with all the information they needed or asked for and
that he actually followed their advice.
But the Commissioner argues that even if Gaggero proved reliance, he didnt
show that his reliance was in good faith. See ASAT, Inc. v. Commissioner, 108
T.C. 147, 176 (1997) (mere shifting of responsibility to the tax preparer does not
relieve a taxpayer from liability for the accuracy-related penalty (citing Enoch v.
Commissioner, 57 T.C. 781, 802 (1972))). We acknowledge that Gaggeros
practical knowledge is unusual compared to his education. Though he never
graduated from high school, his experience and skills have given him a keen
understanding of the world. For example, during trial he didnt hesitate to
question his attorneys advice, suggested cross-examination questions, and

- 53 [*53] showed a deep understanding of the concept of tax basis in forming his own
opinion on the IRSs approach on reporting the capital gain. This worldly
understanding, according to the Commissioner, made him consciously aware that
the tax consequences of the transaction were too good to be true. Sec. 1.66623(b)(1), Income Tax Regs.; see also sec. 1.6664-4(b)(1), Income Tax Regs.
(Generally, the most important factor [under the facts and circumstances test in
determining reasonable, good-faith reliance] is the extent of taxpayers effort to
assess the taxpayers proper tax liability). The Commissioner even argues that
Gaggero may have carefully planned to file the erroneous return intending to claim
ignorance if caught.
We disagree. Our impression of Gaggero during the trial was of an honest
craftsman who followed professional advice of his long-term consultants, a man
who had to fight the IRS and then learn the case well enough to be familiar with the
terms of the somewhat obscure issues that it raised.
The Commissioner insists, however, that Gaggeros behavior before and after
filing the return precludes any finding he was acting in good faith. He argues that
Gaggero created two sets of documents for the sale to Monticello--one for the
parties to the sale, and one for the IRS. He pointedly argues that Gaggeros
contradictory descriptions of the houses ownership during the closing with

- 54 [*54] Monticello do not correspond with an honest belief that he had actually
transferred an interest in his property to BCC before the sale to Monticello. The
Commissioner also argues that Gaggero hid the sale to BCC from Monticello, his
own real-estate attorney, and the local tax collector. He argues that Gaggeros
signature on the purchase agreement with Monticello certified he had not executed
any other sales contract for the sale of the property, effectively denying the
existence of the Sale Agreement and even contradicting it. And he points out that
Gaggero stated twice in the owners declaration that no other persons asserted
ownership in the property and delivered that declaration to Chicago Title Insurance
Company. The deed to Monticello and the estimated settlement statement do not
mention the terms of the Sale Agreement. And Gaggero explained that his full
ownership of BCC made only the essence of his declaration true--There is nobody
out there that Im aware of thats going to make a run at this property other than that
which I represent. This, the Commissioner contends, amounts to Gaggeros
admission that he prepared two mutually exclusive versions of the same transaction,
which indicates lack of good faith.
Well. The problem here for the Commissioner is that were not looking at
Gaggeros good faith in the transaction as a whole--where he had to deal with a
hard-nosed third party in Monticello and what seems to have been a very

- 55 [*55] contentious relationship with a real-estate broker who wanted by turns to


profit from the deal or torpedo it. Were looking instead at whether he reasonably
relied in good faith on the advice of his professional tax adviser. And with both
Walters specifically and K&A more generally, Gaggero made sure he was honest
and completely forthcoming and that he followed their advice.
Gaggero consulted with K&A about the allocation of the sale price between
BCC and himself. K&A, and in particular Walters, were expert tax advisers and
competent in the tax matters at issue in this case. It was K&A who advised
Gaggero how to report the transaction and to roll over the sale proceeds into another
personal residence so that the gains from the sale would qualify for deferral under
section 1034. The fact that the transaction began six years before its reporting
reinforces our belief it had true and genuine economic substance, and we attribute
the partial inaccuracy of the reporting as due solely to Gaggeros tax preparer.
We agree with the Commissioner on the amount of the gain that Gaggero
must recognize, but do not sustain the penalty, so

Decision will be entered


under Rule 155.